The Growth Allure

Lewin and Peters, researchers at Duke University, in their annual offshoring survey, found that offshoring is increasingly motivating firms to seek opportunities for growth. In an article in the March 2006 issue of the Harvard Business Review, the researchers point out that the realization that a large and very able talent bank resides overseas is informing more decisions about what to do there: Seventy percent of respondents cited access to qualied personnel as a major driver of their initiatives, up from 54% a year ago. So, although a firm may initially use overseas talent to save costs and free up high-cost U.S. talent to pursue growth, it is not long before the overseas talent come up with better ways of working and ideas for process improvement. As the company gains confidence in their performance and becomes comfortable managing the relationship, it gives them increasingly complex jobs. Ultimately, the offshore talent is empowered to develop ideas and growth strategies for the local market.

The article offers some interesting statistics to support its case:

During the first wave of offshoring, which centered on contact centers and IT, the ratio of jobs created offshore to jobs eliminated in the United States was 1:1 – consistent with a strategy of taking out cost. In the current wave of offshoring, which includes far more innovation and product development than the first wave did, the ratio of jobs created offshore to jobs eliminated in the United States is 13:1 – consistent with growth. Follow-up interviews and several case studies suggest that offshoring allows companies to increase the number of engineers and researchers while keeping constant the cost of product development as a percentage of sales.

So, companies must not view offshoring as a narrow palliative for the bottom line. As the offshore workforce becomes more skilled, companies that leverage it to increase growth will find it an integral component of firm competitiveness.

So, is this also a shift from third party service providers to captive outsourcing? That's the subject of another post.

The Truth on Offshoring

In a study released yesterday by the Association for Computing Machinery, a task force of computer scientists, social scientists, and labor economists from around the world took a hard look at the forces shaping the migration of jobs worldwide in the computing and information technology fields. Prior to this effort, no study has looked at offshoring on a global scale.

Myths were debunked. While you can read the study in its entirety at the ACM website, here's a quick look at the key findings and recommendations - each of these areas is explored in detail in a chapter of the report:

1. Globalization of, and offshoring within, the software industry are deeply connected and both will continue to grow. Key enablers of this growth are information technology itself, the evolution of work and business processes, education, and national policies.
2. Both anecdotal evidence and economic theory indicate that offshoring between developed and developing countries can, as a whole, benefit both, but competition is intensifying.
3. While offshoring will increase, determining the specifics of this increase are difficult given the current quantity, quality, and objectivity of data available. Skepticism is warranted regarding claims about the number of jobs to be offshored and the projected growth of software industries in developing nations.
4. Standardized jobs are more easily moved from developed to developing countries than are higher-skill jobs. These standardized jobs were the initial focus of offshoring. Today, global competition in higher-end skills, such as research, is increasing. These trends have implications for individuals, companies, and countries.
5. Offshoring magnifies existing risks and creates new and often poorly understood or addressed threats to national security, business property and processes, and individuals' privacy. While it is unlikely these risks will deter the growth of offshoring, businesses and nations should employ strategies to mitigate them.
6. To stay competitive in a global IT environment and industry, countries must adopt policies that foster innovation. To this end, policies that improve a country's ability to attract, educate, and retain the best IT talent are critical. Educational policy and investment is at the core.

In essence, globalization and offshoring are inevitable. They're not the threat they're made out to be. However, leveraging this global information technology field will require deep grounding in the fundamentals of computing, new knowledge surrounding business processes and platforms, and a deeper understanding of the global community in which work will be done. The educational systems that underpin our profession will need to change.

Like the study concludes, "the future of IT is exciting, but it is a future very different from the past, and even from the present".

Risk Management in BPO

An important finding in my research on governance of BPO relationships was that when firms outsource a business process, they also tend to outsource the risk associated with the execution and management of the process. Not surprisingly, these relationships are marked by high levels of dissatisfaction.

Protiviti, an independent provider of internal audit and business and technology risk consulting services, has a good article on the risks involved in outsourcing and the management of such risks. The risks described in the article are firm- or relationship-level risks. No macro risks such as political or economic risks are outlined here. The risks are broadly classified as project planning and management risks, supplier selection risks, contracting and negotiation risks, transition and start-up risks, and contract and supplier performance risks. While the article does not offer a recipe for risk management, it does provide a thought framework to analyze the risks involved in outsourcing.

Risk management, according to my empirical analyses of survey data on more than 140 companies, boils down to the following processes:

Know thy outsourced process - Firms often outsource complex processes that are not executed or managed efficiently in-house. This is a recipe for dissatisfaction. Firms must attempt to untangle complexity and outsource processes whose requirements can be efficiently communicated to the service provider.

Analyze the outsourced process - Examine complexity, strategic importance, and interdependencies of the outsourced process to clearly define outsourcing objectives and functional requirements.

Govern well - The governance structure must reflect the unique nature of the outsourced process. The article focuses on the contract as the governance solution, which is also the mistake that most firms make. The contract must be complemented by investments in processes and technologies that execute the contract to realize efficiency gains in outsourcing.

Think

Here're some interesting statistics culled from the McKinsey Quarterly website. For a complete list of statistics, check the Quarterly's website:

Total world cross-border trade as a percentage of global GDP
1990: 18%
2015 (estimated): 30%

Number of regional trade agreements
1990: 50
2005: 250

Change in Germany's population over the age of 75 from 2005 to 2015: 33%

Increase in tax burden needed to maintain current benefit levels for Germany's future generation: 90%

Change in Japan's population over the age of 75 from 2005 to 2015: 36%

Change in Japan's population under the age of 5 from 2005 to 2015: -13%

Increase in tax burden needed to maintain current benefit levels for Japan's future generation: 175%

Number of US tax returns prepared in India
2003: 25,000
2005: 400,000

Growth rate of the total wealth controlled by millionaires in China from 1986 to 2001: 600%

Estimated number of Chinese households to achieve European income levels by 2020 (assuming real income grows at 8 percent annually): 100 million

Total number of workers in China: 750 million

Number employed in China's state-owned companies: 375 million

Year when the income gap in the United States between the wealthiest 5% and the bottom 10% was the widest ever recorded: 2004

Number of coal-fired power plants China plans to build by 2012: 562

Estimated year China will overtake the United States as the number-one carbon emitter: 2025
Estimated year CO2 levels will hit 500 parts per million: 2050

Years since CO2 levels last hit 500 parts per million: 50 million

Global CEOs who think overregulation is a threat to growth: 61%

Probability that a company in an industry's top revenue quartile will not be there in five years: 30 percent

Complementarities between Internal and External Collaboration

I was reading an article in the Financial Times - "Why in-house collaboration is so difficult" on how managers often lament the lack of collaboration among internal business units and the loss of synergies that results.

The article points out that most research in this area presumes that collaboration is necessary. However, in some cases, presumed synergies are a mirage or the opportunity costs of developing synergies are too large. Problems may also arise if there are operating skill issues (when no manager has sufficient expertise to judge which unit has best practice), chemistry issues (when bad past experiences have poisoned relationships) or systems issues (when the IT system cannot provide the data needed for a collaboration).

In light of these reasons, the article suggests four steps to take when approaching problems in collaboration:

• First, managers should put more effort into calculating the size of the prize, a cost-benefit analysis of a tightly defined synergy opportunity. Unless the benefits are a multiple of the costs, the collaboration is probably not worth the effort.
  
• Second, once the prize is clear, managers can investigate why collaboration is not already happening. Typically, there are precise reasons connected with relationships, competing priorities, resource constraints, insufficient skills of a particular kind or other operational issues.
  
• Third, once the reason for inaction is clear, managers can assess whether they have the skill and will to unblock the problem. Sometimes it requires hard choices in terms of restructuring or personnel changes, sometimes hands-on expertise on the part of managers.
  
• The fourth step is to look out for the downside - distraction costs, contamination risks, loss of accountability, initiative and motivation. There is a dark side to collaboration that is all too apparent in some companies. In these organizations, it is politically correct to collaborate, regardless of the cost.

The above suggestions imply that internal collaboration involves attention to much the same issues as external collaboration. I had earlier posted results of my research on governance of BPO relationships - they emphasized that a one-size-fits-all approach to governance fails to establish appropriate baselines for governance, does not adequately prepare managers for the transition, and limits ways to create value and improve performance in the relationship. In other words, the governance solution must reflect the unique nature of the outsourced process to realize efficiency and service satisfaction gains in BPO.

So, if the outsourced process or function is complex, strategically important, and shares strong interdependencies with other business processes, the client firm might adopt a partnership approach to governance and make the shift from control to coordination and penalties to shared risks and rewards. If not, the shift may not merit the additional complexity of relationship management. An arms length contract that emphasizes penalties and control may be the most efficient means to leverage scale efficiencies and skill of the service provider.

Notably, this points to complementarities between internal and external collaboration. If an organization develops the capabilities that facilitate synergy and collaboration between business units, it can leverage such knowledge and capabilities to collaborate successfully with its external partners as well.

How clean is your house?

US growth pegged to the yuan

According to the Bureau of Economic Analysis, U.S.-affiliated companies in China - companies in which U.S. firms have at least a 10% stake - earned $3 billion in 2004. That's up from zero in 1990. The Wall Street Journal reports that Joseph Quinlan, chief market strategist for Bank of America, says that figure is a good reflection of how U.S. companies are making out in the world's fourth-largest economy. He estimates earnings reached a record $3.2 billion in 2005.

Earlier impressions of China as a black hole for investment are fast disappearing. The country is fast becoming an attractive market for U.S. companies, even in most competitive industries. Even as it piled up losses in the U.S., General Motors Corp. reported income from China of $218 million for the first nine months of 2005. China accounts for 12% of Motorola Inc.'s global sales and is by far the biggest market for the company outside the U.S. General Electric Co. said top-line revenue in China hit $5 billion last year, and the company is aiming to double that by 2010.

So, contrary to popular belief, a majority of the U.S. investment in China ($4 billion last year)is aimed at the domestic market. And this seems a fairly natural progression. More so in the case of service economies like India where in addition to costs, skills and expertise are actively considered in the decision to outsource. Companies vie to attract such talent with the promise of lucrative careers and growth paths. This triggers relatively sustainable growth in the economy and when exports are broad-based (such as manufacturing in China), the extent of such growth is higher. Therefore, the U.S. firms have a growing market to cater to and when that market is 1 billion people strong, even garnering a fraction of it is a win strategy. Firms that offshore are the ones which will reap the highest profits in the economy.

However, it's necessary that firms talk more about their profits from these quarters. Legislation proposed by Sen. Charles Schumer, a New York Democrat, would impose a 27.5% tariff on Chinese goods unless Beijing lets its currency rise faster against the dollar. After hearing Friday that the U.S. trade deficit with China ballooned to a record $201.62 billion last year, Sen. Schumer said he may push for a Senate vote on the bill next month. In addition to explaining that the US will lose in this move, Schumer must be convinced that not all firms will lose equally.

A new bottle for old wine

I attended a seminar by Leslie Young last week, which examines the much debated India-China dichotomy through a new lens. Among other things, Young talks about long-term economic relations, environmental sustainability, and social stability of these growing economies. I found a downloadable copy of the presentation here:

http://www.iscr.org.nz/worksinprogress/work_74.pdf

Offshoring and Open Source

Deloitte, in the 2006 edition of its predictions for the global technology sector, points out that offshoring will evolve from an option to obligation, and that open source will move mainstream:

...Technology companies should consider taking offshoring seriously, if they are not already doing so. The cost advantage derived from exploiting low labor costs and overheads in emerging markets will likely evolve from being a bonus to a necessity...

...2006 will likely see open source ramp up its challenge to the established software business model, impacting both established software providers as well as end-users. 2006 may well see open-source challenge long-established and credible products and services in CRM, ERP and other enterprise software infrastructure functions, in addition to its growing strength in server management, operating systems and office productivity software...

It's interesting how these two trends share a mutually reinforcing relationship and are essentially two faces of the same coin. First, they are both, enabled by increased technological sophistication, which has amplified the cognitive and social capabilities of the population, and the architecture of the Internet, which has enabled networking of these capabilities. Increased networking facilitates a participatory economy and increased supply and decreased acquisition costs of pertinent capabilities drives down the compensation of the population.

In addition to increased connectivity, both these trends are driven by low costs of such connectivity, including capital and information access. Over the past few years, there has been a significant decline in the price of computing, storage, and communications technologies, for a given level of performance. Enabled by inexpensive computing technologies, information search and creation capabilities have rapidly matured to become more sophisticated and pervasive. Sophisticated search technologies have helped to address the classic tension between recall and precision, not by increasing the volume of information retrieved but by improving the quality of retrieved information through significant mitigation of unrelated and unusable information sources. And all of these have been ably supported by the spread of broadband access. So, open source as well as offshore teams are rapidly scalable and can produce value at relatively lower costs of ownership.

Finally, they both require of the project high modularity and low complexity which enables disaggregation of project components. The characteristic of software projects that allows them to be modified in distributed teams is also one that drives their design and development across geographical and temporal boundaries.

The mutually reinforcing relationship is evidenced by what Irving Wladawsky calls the "outside-in" paradigm. This emphasizes that businesses, governments and other institutions embrace open standards internally, driving down the transaction costs of communicating and collaborating with service providers. Reduced integration costs increase adoption of offshoring. In an allied fashion, as offshoring increases, the greater the need for the supporting technology and infrastructure, and the greater the levels of open-source development.

It would be interesting to dwell on how these two trends work as substitutes instead of complements. That's the subject of another post.

Meanwhile, let's just get used to global integration. It's inevitable.

From Penalties to Rewards - A Rational Shift?

In its 2005 Global IT Outsourcing Study, consulting firm DiamondCluster International Inc. found that 27% of buyers responding to the survey said they were issuing rewards last year, and most coupled them with penalties. An additional 48% administered only penalties yet are coming under increasing pressure from providers, 44% of which include rewards in their typical outsourcing deals, the study found.

The Wall Street Journal highlights how clients of outsourced services are shifting emphasis from penalties for non-performance to incentive structures that drive the provider to push the service envelope. While the structure of incentives varies widely, many focus on sharing the savings from cost reductions and the spoils from greater performance.

This shift from penalties to a shared reward system is reflective of a larger shift in the nature of the outsourcing relationship from an arm's length contractual arrangement that focuses on the specific terms of work to a partnership model that is sustained by the future value of the relationship. Therefore, negotiation and execution of incentive structures require more planning, attention and resources relative to a penalty system. Given the complexity involved in executing an incentive structure, one must ask - is this shift from penalties to rewards really required? What is the marginal increase in performance that will accrue on account of this shift?

The shift is not for all. If the process or function outsourced is complex, strategically important, and shares strong interdependencies with other business processes, the client firm might find the shift well worth the additional effort required to shift from control to coordination. If not, the shift may not merit the additional complexity of relationship management. An arms length contract that emphasizes penalties and control may be the most efficient means to leverage scale efficiencies and skill of the service provider.